Wednesday, May 20, 2009

Business Lending by banks

why do business firms borrow from commercial banks? A nationwide sample survey conducted by the survey Research center of the University of Michigan shows that business firms mainly borrowed to secure either working capital or funds for capital expenditures. Borrowing for working capital includes such purposes as building up or carrying inventories, seasonal credit, borrowing for financing sales or credit to customer, discounting receivables, and the like. the latter purposes all fall within the traditional doctrines of the proper use of bank credit, whereas the use of bank credit to finance capital expenditures does not.

excess member bank reserves

Total and excess reserves of member banks are affected through open market operations or through changes in reserve requirements. Excess reserves of member banks are equal to total reserves minus required reserves. When the Federal Reserve lowers reserve ratio requirements,or when it provides added bank reserves through open market operations,the immediate effect of these actions is to increase excess reserves of member banks. Ordinarily,it can be assumed that added excess reserves will be quickly put to work earning more profits for the bank in increased loans or increased investments.
But this profit motive to utilize virtually all increases in excess reserves seems to be stronger for large city banks than for smaller banks. Although in recent years all banks have tended to ave small amounts of excess reserves,the tendency of large city banks in New York City and Chicago to approach zero excess reserves .In some months in 1976 these banks even had negative excess reserves,which indicates the extent of their efforts to maximize their profits by tending toward zero excess reserves.
Borrowings in this period were relatively small from the Federal Reserve banks,since this was a period of credit easing and loanable funds were in ready supply. The bulk of member bank reserves were held at the regional Reserve banks.Nevertheless some $7.5-$8.5 billion were held as vault cash in the form Federal Reserve banks in the of currency and coin to satisfy the cash needs of customers.there was some increase in borrowings at the federal Reserve Banks in the last quarter of 1976 and some increase in borrowing at the federal Reserve Banks in the last quarter of 1976 and some increase in holdings of currency and coin.

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2- [[Primary Bank Reserves ]]:

Tuesday, May 19, 2009

Primary Bank Reserves

Primary Bank Reserves are simply cash held by the bank, whether in its vaults or in deposits of other banks. The Federal Reserve System, however, does not permit its member banks to include in their legal reserves interbank deposit in other commercial banks, though it does include deposits in regional Reserve Banks. Nevertheless, for many purposes, other than meeting legal reserve requirements, deposits in other banks meet all the requirements of ready cash.
The amount of primary, or cash, reserve available to a given bank depends upon two major factors; (1)deposits flows in or out of the bank, and (2) the prevailing Federal Reserve policy, including changes in such policy. The federal Reserve, of course, has ultimate control over the amount of bank reserves available to the banking system. in addition to the amount of cash reserves available, the primary reserve position of the bank or the entire banking system also depends upon the amounts of reserve that are required. These required reserves depend not only upon the amount of bank deposits but also on their distribution between time and demand deposits. Legal reserve requirements also affect the amount of required reserves.
MEMBER BANK RESERVE REQUIREMENTS in 1935 congress gave the Board of Governors of federal Reserve System the power to impose reserve requirements on both demand and time deposits within a certain range on each set by Congress. At that time legal reserves of member banks were defined as being only deposits in the federal Reserve Banks. In 1959 Congress again amended the basic Federal Reserve Act in order to permit vault cash as well as deposits in federal reserve banks to be included in legal reserves.
LAGGED RESERVE ACCOUNTING The required reserve base for all member banks is computed against average daily deposits for the weekly reserve period, which runs from Thursday to Wednesday inclusive. In 1968 the federal Reserve introduced lagged reserve accounting, so that required reserves for the current reserves week are now based on average deposits in the period two weeks earlier. furthermore, member banks are permitted to carry forward into the next reserve week either excess or deficiencies averaging up to 2 per cent of required reserves.

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Sunday, May 17, 2009


BANK RESERVES were originally required by various states before the civil war to provide for convertibility or redeemability of bank notes. following the panic of 1857 and the national bank Act of 1863, a number of regulatory agencies required reserves against both bank notes and bank deposits. These required reserves could be either in the form of lawful money or in correspondent balances in other banks. Some states also permitted banks to include certain securities,such as federal government securities and certain state and local government securities,in their legal reserves.
Regardless of the form of bank reserves,they were invariably regarded as being necessary to maintain bank liquidity. In other words,banks in their search for profits had to be prevented by the regulatory authorities from an over-extension of bank credit,wherein particular banks might be unable to satisfy the claims of their creditors in an emergency period. Today,however,it is recognized that liquidity for the banking system as a whole depends ultimately upon the ability and willingness of the Federal reserve to supply additional funds to the banking system when needed.Reserve requirements now are regarded as a fulcrum,or pressure point,whereby the monetary authorities can make effective their desired monetary-credit policies. However,this fulcrum of legal reserve requirements applies only to a certain amount of the primary,or cash,reserves of a bank.

Saturday, May 16, 2009

bank lending and liquidity

the pattern of bank is lending business, as well as the character of its deposits, also helps determine its needed liquidity ratio. the economic structure of the community in which the bank is located will affect both the seasonal and the cyclical nature of loan demands that converge on the bank in question. the composition and maturity pattern of a banks loan portfolio, as well as the character of its investment portfolio, greatly influence the liquidity needs of a particular bank. a bank that has a loan portfolio with well-spaced maturities of loans, or a bank that has a high proportion of government notes or bonds falling due within a year or two, may feel less need for a high ratio of liquid assets to deposit than another bank that is not so fortunately situated.
Management Attitudes,Certain management attitudes or predilections may also determine the felt liquidity needs of a particular bank. Some bank managements simply have more risk aversion or are more conservative in their attitudes than others. we would expected a more conservative bank management to wish to hold a higher proportion of liquid assets than another bank with a somewhat less conservative management. Also, the attitude of given bank 's management toward borrowing from the regional reserve bank is important. those member banks that are willing to borrow whenever necessary and possible would presumably need a somewhat lower liquidity ratio than banks that borrow seldom, if at all, from the federal reserve.
LARGER AND SMALLER BANKS, The level of primary reserve that is legally required may also help explain certain of the differences between, say, larger and smaller banks. Those larger member banks of the federal reserve System that are city banks have always had higher legal reserve ratios imposed upon them than on those smaller member banks classified as "all other member banks" which were formerly called country banks. Any member bank that has over $400 million in net demand deposits had a legal reserve ratio of 16.25 per cent applied to all of its demand deposits over $400 million in 1977. the downward pressures on bank profits, which these higher reserve requirements imply, may help explain a seemingly greater interest on the part of city banks in investing a higher proportion of the available resources in higher-yielding assets in the maturity and risk area beyond those of the most highly liquid assets. furthermore, such city banks, as we have already indicated, tend to have a low level of excess primary reserves.

Do modern-day checks satisfy the desired properties of money?

obviously checks are easy to carry around (portable), can around (portable), can be written in various amounts (divisible), and are reasonably durable. However, checks are not always of recognizable value. if a stranger offers you a $30,000 check for your car, chances are you will not hand over the keys. the problem is that you do not recognize the true value of the check-it may bounce, in which case you are out one car. Recent advances in electronic check verification,however, are making it easier for some check recipients (primarily businesses) to verify checks quickly.

trading places : Auction and over-the-counter markets

Secondary financial markets also can be categorized according to how assets are traded between buyers and sellers.The first is auction markets,in which prices are set by competitive bidding by a large number of traders acting on behalf of individual buyers or sellers. The most common auction markets are exchanges,or central locations at which buyers and sellers trade. These include the New York and American Stock Exchanges, the Tokyo Stock Exchange,the London stock Exchange,and others.
Secondary markets also can be organized as over-the-counter(OTC)markets,in which there is no centralized place for auction trading.Over-the-counter dealers buy and sell stocks and bonds through computerized trading to anyone willing to accept their posted prices.Close electronic contact keeps the over-the-counter market competitive.You are unlikely to pay a much higher price for a share of stock in Newco at one dealer than at another.
The equities of the largest corporations are traded on exchanges,as are the bonds of the most well-known corporations. The shares of smaller,less well-known firms are generally traded in over-the-counter markets,as are U.S.government bonds.The market for these bonds has the largest trading volume of any debt or equity market.Other major OTC markets include those for foreign exchange,federal funds,and negotiable certificates of deposit.

Friday, May 15, 2009

corporate stock

A share of corporate stock is an equity instrument that represents ownership of a share of the assets and earnings of a corporation.When a corporation like AT&T needs long-term funds,it can sell shares of stock to individuals or other investors. AT&T uses the funds received to purchase assets and run the company;in return,the shareholder owns a share of these assets and the earnings they generate for AT&T.The profits earned by a corporation and paid to shareholders are known as dividends. Unlike interest payments,dividends can vary with the health of the company.
It is important to emphasize that the only time a corporation receives money from stock is the time at which it issues the stock--the primary market transaction. When the company decides to issue stock,it offers the shares to underwriters,investment banks that guarantee the firm a certain price for the issue. Then the investment banker (or bankers,if the issue is large)sells the stock to individual investors,with the assistance of brokers,at what they hope is a higher price than the guaranteed price. Effectively the underwriters provide insurance to the company issuing the new stock and bear the risk associated with the low price investors pay for the stock.
Once a new issue is in the hands of individual investors, the stock can be sold and purchased by another investor(with the aid of a broker)in a to the corporation.Individuals own the majority of stock in the United States,and pension funds,insurance companies,and mutual funds own the remainder.

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international financial instruments

Tremendous growth has occurred in international financial instruments in recent years. for the most part, the financial instruments traded in international markets function like the instruments issued in the U.S. the only difference is that the unit of account for these instruments is the local currency of the country in which they are issued. for instance, bonds issued in Britain are denominated in British pounds, while bonds issued in Germany are issued in German marks. Both are foreign bonds to U.S. residents.Eurobonds are an important exception. Eurobonds are bonds denominated in a currency other than that of the country of origin. for example, a bond issued in Germany but denominated (paying interest and its face value) in U.S. dollars is a Eurobond.
The recent surge in activity in world stock and bond markets has broadened the possibilities for investors and borrowers alike. A borrower no longer has to obtain funds from financial intermediaries in his or her own country;similarly, a lender need not to borrowers in its own country.
Because of time differences across the globe (when it is 4 A.M. in New York,it is 9 A.m. in London) international markets allow borrowers and lender to make financial transactions at virtually any time of day. This fact has greatly enhanced the liquidity of financial assets that trade on exchanges around the world.

Thursday, May 14, 2009

indirect financing

Indirect financing occurs as a result of financial institution acting as intermediaries,perform the function of channeling saving funds from household(ultimate lenders)to businesses (ultimate borrowers).For example,commercial banks and other depository institutions accept monetary liabilities,such as demand deposits and savings deposits,and insurance companies accept monetary liabilities,such as payment of premiums that obligate the insurance companies to reimburse expected losses.In turn,financial institution purchase assets (relend the funds). for example, commercial banks purchase IOUs from businesses, and thrift institution purchase mortgages from home buyers (this latter transaction implies a relending back to households).

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direct financing

Businesses can start up or expand by obtaining funds directly from households.One way to do so is by selling common stock to the public.Common stock is evidence of part ownership in a corporation;it entitles the owner to vote on certain corporate decisions and to share in any profits.A share of common stock is a financial asset to the owner and a financial liability to the issuer,or corporation.A business can also obtain funds by issuing (selling)bonds.A bonds is evidence that a promise has been made by a corporation to pay a specified amount of money in recognition of a loan to the business.The bond is a financial asset to the lender-owner and a financial liability (debt)to the borrower-corporation.
In bot these examples,direct financing has occurred;businesses have borrowed directly from households.In turn,businesses use these saving funds to make purchases of plant,equipment,and inventory.Markets have evolved to facilitate direct financing.Stocks and bonds are originally sold primary markets;often they are resold(many times),through transactions taking place in secondary markets.Primary and secondary markets are analyzed below.

Wednesday, May 13, 2009

Negotiable Bank Certificates of Deposit

Certificates of Deposit (CDs) are debt instruments sold by banks and other depository institution. A CD pays the depositor a specified amount of interest during the term of the certificate, plus the purchase price of the CD at maturity. For example, a $1,000,one-year CD paying 5 percent interest would pay $1,000 plus $50 interest at the end of one year (the term of the CD). today negotiable CDs are sold in large denominations (over $100,000) and can be resold in the secondary market. this makes negotiable CDs highly liquid. the original purchaser need not hold the CD to maturity or pay "a substantial penalty for early withdrawal" if he or she needs to liquidate the CD.Instead,the person can sell the CD in the secondary market at a price that will depend on the market interest rate in effect when it is sold.the use of CDs grew from $119 billion in 1976 to $416 billion in 1992.

Tuesday, May 12, 2009

Repurchase Agreements

A Repurchase Agreements (or simply repo)is an agreement by two parties in which the borrower sells and agrees to buy back a financial instrument such as a government bond,note,or T-bill. Suppose a bank needs short-term cash today. The bank can sell some Treasury bills to a firm such as IBM with the agreement that the bank will repurchase the T-bills in 30 days at a higher price.In effect,this repurchase agreement is a short-term loan in which the Treasury bills serve as collateral.repurchase agreements accounted for $71 billion of liquid assets in the United States in 1992.

Federal Funds

Suppose it is 222:50 p.m. and a bank needs $10 million by 3:00 p.m. to meet the reserve requirements set by the Federal Reserve. Obviously it is too late to attract additional deposits,and the bank must find a quick way to acquire the funds. One way the bank can obtain such funds on short notice is to acquire federal funds. Federal funds are simply short-term (usually overnight)loans between banks. The funds are loaned at an interest rate known as the federal funds rate. They are called federal funds because they are held in deposit at the Federal Reserve rather than because they are loaned by the federal government. In fact,the transfer of federal funds is merely a bookkeeping transfer from the ledger of a bank with an excess of reserves to the ledger of a bank with deficient reserves.

Banker's Acceptance

A Banker's Acceptance is letter of credit (a bank 's promise to pay on specific date) that has been stamped as " accepted" (guaranteed) by another bank. You might think of A Banker's Acceptance as analogous to a post-dated "check" or bank draft. If the party issuing the check has insufficient funds in the account to cover the draft when it is payable, the bank that stamped the draft is obligated to pay the amount of the "check" to the party who holds it. Obviously a Banker's Acceptance is more valuable as a medium of exchange than a standard check, since a bank guarantees that the Banker's Acceptance will be honored. the party issuing a banker 's acceptance pays a fee to the bank for its guarantee.
A Banker's Acceptance are particularly valuable in international transactions, since it is extremely costly for firm located in, say, France to recover a bad check from a party located in Egypt. there is a relatively small secondary market for Banker's Acceptance, which essentially operates as a scaled-down version of the market for Treasury bills. that banker is acceptance accounted for only $23 billion of the outstanding money market instruments in 1992.


Eurodollars are U.S. dollars deposited in banks located in other countries. foreign banks and offshore branches of U.S. banks hold dollar deposits to service firms engaged in international trade, as well as for other purposes.U.S. banks sometimes borrow Eurodollars when they need short-term funds. the growth of the Eurodollars market in the 1970s was spurred by the relative lack of regulations on these funds, including the absence of regulations requiring banks to hold reserves against Eurodollars loans . that Eurodollars increased from $14 billion in 1976 to $56 billion in 1992.

banks as depositories

Banking existed in Babylonia and in ancient Greece and Roma. During the Middle Ages, gold and silver (Known as specie, from The Latin for "in-kind" served as a full-bodied medium of exchange. People naturally wanted to store their specie in a location safe from theft, fire, and other hazards. Such a location required some sort of safe or strongbox, and the town goldsmith was one place that invariably offered such accommodations. Other wealthy individuals or businesses also had strongboxes for their own valuables and leased space in them to others, but goldsmiths of necessity had strongboxes to store the gold they used in their trade.

Sunday, May 10, 2009

Pension funds

private and government (including federal,state,and local)pension funds provide retirement income to employees covered by the pension plan.Funds are collected by regular contributions from employees,usually via payroll deduction. Since the funds flowing in are not demand deposits,you cannot write a check against your balance in a pension funds.Like life insurance companies,these institutions can accurately predict payouts and hence can hold long-term assets. They hold portfolios consisting mostly of stocks and bonds. The returns on these assets are paid out to participating individuals wen they reach retirement age.

Insurance Companies

Insurance Companies protect individuals against risk.Life insurance companies accept regular payments from individuals in exchange for contracted payments in the event of the insureds' death. By insuring a large pool of individuals,life insurance companies can consult actuarial tables and predict very accurately what percentage of the insured individuals will die each year.Because of this ,life insurance companies old long-term assets,including long-term bonds. They also old substantial quantities of commercial real estate. Loans make up only about 24 percent of assets,and the majority,roughly 20 percent,are mortgage and other real estate loans. The bulk of life insurance company assets,around 76 percent,are not in loans. This is in sharp contrast to both commercial banks and savings and loans. Furthermore,the assets insurance companies hold are purchased with insurance premiums rather than deposits. Thus,it is not possible to write a check against an insurance policy.
Other insurance companies,called fire and casualty insurance companies,insure against loss from fire,theft,and accident.If you own a car or a house,you probably have purchased this type of insurance.Insurance claims on these policies are somewhat less easy to predict. More important,the duration of the liability (e.g.,the"life expectancy" of your car)is lower than for life insurance,so these companies usually invest in more liquid, shorter-term assets.

how did bank loans evolve?

as society began using commodity money as a medium of exchange,a need for a safe place to deposit money developed.Early banks were depositories in which individuals paid a fee for the privilege of depositing commodity money such as gold.Due to the transactions costs associated with having to go to the bank to obtain gold to use in transactions,demand deposits (checking accounts)and bank notes emerged. As these forms of "paper money"became widely accepted as the medium of exchange,banks recognized they had much more gold in their vaults than they needed to honor demands for gold by depositors. Consequently,they began loaning out a fraction of their deposits to earn additional profits in the form of interest payments. Today,banks function as middlemen,or intermediaries,in financial markets by (1)borrowing sort and lending long,(2)pooling small deposits into large loans,(3)diversifying risk,and (4)economizing on transactions costs relative to engaging in direct finance.

Saturday, May 9, 2009

a zero Coupon Bonds

As the term,the owner of a zero Coupon Bond receives no regular interest payments, since the bond has no coupons attached. Instead, the bond is sold at a discount from its face or redemption value. The change in value from its price at issue to its redemption value is implicit interest that the purchaser receives on the bond. for example, azero coupon bond might have a redemption value of $1,000 one year from today. A lender might purchase this bond for $900, meaning the interest on the loan is effectively $100. The implicit interest rate is than $100\$99, or 11.11 percent.

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Coupon bond

A Coupon bond specifies (1)a face value,(2)a term, and (3) the coupon rate, which is the percentage of the face value that will be paid annually as interest when the holder redeems coupons attached to the bond at specified points in time (say, every six months). These coupons gave coupon bonds their name. Upon maturity, the bondholder redeems the bond for the face value. If the bond is sold to the lender at face value (or par),the face value is the principle and the coupons represent the interest on the bond. For example, Suppose your bank purchases a 10 percent coupon bond at the face value of $10,000. In this case, the principle is $10,000-the price at which the bond is sold to the bank. Annual interest receipts are $1,000, or 10 percent of the principal amount. Sometimes coupon bonds sell at other than face value.

commercial paper

commercial paper is a from of direct short-term finance by large,creditworthy company such as A&t needs immediate funds,it can sell commercial paper(a debt instrument)to another corporation or financial institution. Commercial paper is a promise to pay back a higher specified amount at a designated time in the immediate future---say,30days. By issuing commercial paper,a corporation avoids the process of applying for a loan and instead engages in direct finance. To engage in direct finance effectively,the issuing company must be large and creditworthy enough to find someone willing to accept its commercial paper,which is sold with the aid of brokers.the use of commercial paper grew from $50 billion in 1976 to $339 billion in 1992,an increase of about 12.7 percent per year. The growing use of commercial paper has increased the competitive pressure on banks,which are finding some of their potential loan customers turning to the commercial paper market.

Friday, May 8, 2009

Which has more liquid assets of commercial bank or insurance company? Why?

commercial banks are depository institutions, whereas life insurance companies are not. A depositor at commercial bank can withdraw funds on demand by writing a check,whereas the owner of a life insurance policy cannot write a check against the policy. For this reason, banks tend to hold more liquid assets than life insurance companies do .

Mutual funds

Mutual funds sell shares to investor, and invest the proceeds in a wide choice of assets. Owners of shares receive pro rate shares of the earnings from these assets, minus management and other fees assessed by the fund. Some mutual funds, called money market mutual funds, invest in short-term, safe assets such as U.S. Treasury bills and large bank certificates of deposit. Largely for historical reasons, money market mutual funds are not considered depository institutions even though shareholders are often allowed to write checks on their accounts. Unlike depository institutions, money market mutual funds do not promise that the price of share will stay constant, but in fact, the price of each share tends not to fluctuate over time like prices of stock mutual funds do. Fund managers work to keep share prices constant, and owners of these 'shares' receive a portion of the earnings derived from the assets bought with the money received for the shares. These funds enjoyed widespread popularity in the late 1970s and early 1980s, when they grew at a rate of 37 percent per year.

mutual savings banks

mutual savings banks are much like savings and loans, but are owned cooperatively by members with a common interest, such as company employees, union members, or congregation members. Originally they accepted deposits and made mortgage loans. As with savings and loans, recent deregulation allows the approximately 500 mutual savings banks in the U.S. to issue checkable deposits and engage in financial activities roughly on par with other depository institutions .

savings and loan Associations

savings and loan Associations(S&Ls)were originally designed as mutual associations, (i.e., owned by depositors) to convert funds from savings accounts into mortgage loans. the purpose was to ensure a market for financing housing loans. Over the past 20 years a very active market for mortgages has developed, diminishing the need for regulations forcing S&Ls to concentrate on housing loans. Largely for this reason, during the 1980s government regulation of the types of assets savings and loans can hold was weakened, and today the distinction between S&Ls and commercial banks is minimal. S&Ls continue to hold a less diversified set of assets than commercial banks do.

commercial banks are depository institutions

commercial banks are largest and most important depository institutions. The roughly 12,000 commercial banks in the United States have largest and most diverse collection of assets of all depository institutions. Their main source of funds is demand deposits (i.e., checking account deposits) and various types of savings deposits (including time deposits and certificates of deposit).The major use of funds by commercial banks is making loans. In 1992, loans made up 61.5 percent of commercial banks assets; of these,24.6 percent were real estate loans and 36.8 percent were other loans such as loans to businesses and automobile loans. the remaining 38.5 percent of commercial banks' asset include securities (primarily federal government bonds), vault cash, and deposits at Federal Reserve Banks.

Thursday, May 7, 2009

credit union

credit union are organized as cooperative depository institutions, much like mutual savings banks. Depositors are credited with purchasing shares in the cooperative, which they own and operate. Like savings and loans, credit unions were originally restricted by law to accepting savings deposits and making consumer loans. Recent regulatory changes allow them to accept checkable deposits and make a broader array of loans.

consumer and commercial loans

consumer loans are loans obtained by individuals for intermediate-term purchases such as car purchases, as well as merchandise bought with credit card. Commercial loans are essentially credit lines issued to businesses. there is a less active secondary market for consumer and commercial loans, making them the least liquid of all capital market instruments. However, there has been a growing movement to securitize (convert to marketable securities) some consumer debt.
Automobile loans constituted the largest component of consumer credit, followed closely by revolving credit, which , which includes personal bank lines of credit issued by credit card companies.

Brokerage firms

AS we already noted, Brokerage firms serve the valuable function of linking buyers and sellers of financial assets. In this regard they function as intermediaries, earning a fee for each transaction they create. Unlike garden-variety non-depository institutions, however, modern brokerage firms such as Merrill Lynch and Charles Schwab also compete with depository institutions in the deposit market, where they attract depositors with money market mutual funds. Nonetheless, brokerage firms are not formally considered depository institutions because their main function is to serve as brokers in the secondary debt and equity markets.

financial service markets

Individuals and firms use financial service markets to purchase services that enhance the workings of debt and equity markets. for instance, commercial banks provide depositors not only with interest on deposits but also with a host of services such as check processing, safety deposit boxes, or ATM transactions. Banks use funds on deposit to participate in the debt market (by issuing loans). But Banks really do more than serve as an intermediary; they also provide " convenience," a valuable service that consumers are often willing to pay fees to enjoy. NO secondary market exists for financial services, since people do not sell "used" financial service to third parties.
Another financial service brokerage services. Brokers are intermediaries who compete for the right to help people buy or sell something of value. Real estate brokers help individuals buy or sell houses ; stockbrokers help individuals buy or sell assets such as stocks and bonds. As intermediaries, brokers receive a fee for performing the service of matching buyers and sellers of assets. Dealers differ from brokers in that dealers actually buy and sell securities from their portfolio, and do not just match up buyers and sellers.
finally, financial service markets provide individuals and firms with a means of insuring against various froms of loss, from loss of life to the loss of a valuable painting. These services too are performed for a fee; the proceeds are used not only to pay out insurance claims but also to purchase financial assets in debt and equity markets .
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Equity markets

ownership of tangible assets (such as houses or shares of stock) are bought and sold in equity market. New houses and new issues of stock are sold in primary markets; existing houses and existing shares of stock are traded in secondary markets. An example of a secondary equity market for shares of stock is the American stock Exchange .

debt market

the financial market most familiar to students and professors alike is the debt market. In the debt market, lenders provides funds to borrowers for some specified period of time. In return for the funds, the borrower agrees to pay the lender the original amount of the loan (called the principle), plus some specified amount of interest. Individuals use debt markets to borrow funds to finance purchases such as new cars and houses. Corporate borrowers use them to obtain working working capital and new equipment. Federal, state, and local governments use debt markets to acquire funds to finance various public expenditures. New funds (the issue of a new bond or a new-car loan, for instance)occur in the primary debt market. When an individual or a financial institution buys or sells an existing loan-such as when Sallie Mae buys your student loan-the transaction takes place in the secondary debt market. Assets in the debt market are further classified as short-term if the underlying obligation when issued is one year or less, intermediate-term if the obligation when issued is between one and ten years, and long-term if the obligation is more than ten years in length.

issues in the securitization process(2)

- cash collateral - usually provided in the form of a subordinated loan from the originator.
- the issue of a tranche of junior notes, subordinated to the securities.
- aback-up line or letter of credit from a better-rated bank.
- insurance or guarantees from suitably rated providers.
- over-collateralization within the SPV ie having more than one-to-one asset cover - say 1.25 times - for the securities by the underlying assets.
* achieving off-balance sheet status - there are significant regulatory and accounting hoops be gone through to achieve the necessary separation of the SPV from the originator. These can potentially conflict with the need for credit enhancement and\or continuing administration or servicing of the assets.

issues in the securitization process(1)

where securitization was not contemplated by the bank when the assets were being originated, as is often the case, the process can be along and painful business. It can often take six months to year to complete. The sort of issues that arise include:
* asset homogeneity - the underlying assets have to be similar in character and often documentation between the bank and its customers has changed or been incorrectly completed, altering the nature of the obligations to pay and what happens if payments does not take place. Unacceptable assets have to be identified and weeded out of the portfolio.
* information needs - the rating agencies will require large amounts of information to conduct their detailed analysis. This will include historical information on assets performance trends that might not be readily available.
* credit enhancement - improving the quality of the securities\the ability of the SPV to meet its obligations may be necessary to achieve an appropriate rating. This can be done in a number of ways:

Rating Securitizations (2)

* reviewing the originator of the assets (ie the bank) from both a financial and operational point of view. The latter is important because usually the originator will continue to collect payments due on the underlying assets on behalf of the SPV, although sometimes there is a third-party 'servicer' to carry out this role.
* that even if the originator of the assets becomes insolvent, the investors will still be paid in a timely manner. This means have planned arrangements in place to collect the payments due on the assets even if the administration provided by the originator no longer exists.
for regular issuers, the ratings agencies will carry out audits to ensure standards are being maintained

Rating Securitizations (1)

the securities created have to be sold to investors and they will generally want the comfort of credit rating by at least one of the major rating agencies.
the structure of most securitizations involves the establishment of new special purpose vehicle (SPV) that sells the securities and applies the proceeds to acquiring a pool of assets; say a package of mortgage loans. The amounts received from the mortgage loans are passed on to the securities holders as principle and interest.
The rating agencies will want to be happy with the following:
* that there has been a true sale of the assets to the SPV and that all the legalities needed for it to obtain unequivocal access to the cashflows from the underlying assets have been completed.
* that the underlying assets being securitized are of sufficient quantum and quality to ensure that the securities holders will be satisfied. this will involve looking at asset default rates and their timing pattern as it relates to the transaction; delinquency rates and delays in realizing recoveries are all estimated .

Wednesday, May 6, 2009

why might a lender want to securitize?

there is no single reason but one, or a combination of the following, might apply:
1- to access an alternative source of funds - if deposits, or credit lines, are scare or expensive, securitization of assets, particularly if the securitized assets achieve a higher credit rating than the lending institution itself, can be attractive way of financing the business. Moreover this type of funding can be "matched"- the funding can be for the same tenor as the asset.
2- to release capital - provided the transaction meets the accounting criteria for being off balance sheet, Then the lender will release Scare capital to form the basis for further lending transactions.
3- to improve the return on capital - as long as the income received from the securitization exceeds its costs, the reduction in capital use should ensure that the overall return on capital is enhanced, provided the capital released is used for other profitable transactions (or a capital reconstruction, such as a share buy back.)
4- to improve liquidity - by securitising longer-term assets, using a matched term, the balance sheet can be made more liquid than before.
5- to reduce exposure- exposure to an individual sector, specific types of customer or certain types of asset can be reduced by securitization. This can be an absolute decision to cap or reduce exposure to a category of lending or to create headroom for further transactions.


Securitization is financing technique allowing the holders of financial assets to reconstruct those assets into securities, which are then sold to outside investors. It can also be described as:
* the creation of liquid assets out of illiquid assets;
* the technique of rising funds through the agency of securities;
* the carefully structured process whereby loans and other income producing assets are packaged, underwritten and sold in the form of asset-backed securities, which are typically secured by the underlying pool of assets.

corporate bonds

corporate bonds are bearer securities issued by corporate borrowers with maturities typically of 5-7 years. They can be issued by way public issue private placement and can carry either a fixed or floating interest rate coupon.
In mature and sophisticated capital markets, Such as the US,UK and Europe, investors have the benefit of strong market regulation and rating agency assessments of the credit risk involved in these securities. Rating agencies typically insist on bank back up lines being in place to redeem the securities in the event of a liquidity shortage. In short, investors are protected and well informed about the risks they are taking.
However, commercial paper and corporate bonds are now being issued by corporates in other markets where such protections are not available and there have been some significant investor losses as a result. A proper and comprehensive rating exercise on a company is an expensive business and does not make financial sense to cover relatively small amounts of borrowing. One of the reasons banks exist as intermediaries in loan transactions is because they have specialist skill and experience in credit assessment that is beyond the normal investor. In smaller markets and for smaller companies wherever they are, the need for traditional lending skills is as strong as ever.

credit derivative

credit derivative are a variety of instruments and techniques designed to separate and then transfer the credit risk of the underlying instruments such as loans or bonds.
They work on the principle that it is better to have a diversified portfolio of credit risks than a concentrated one where single risk exposures loom large.The concentration could be a single customer,industry or geographical group.Credit derivative products enable banks to trade and manage their overall credit risk exposure.
There are three major types of credit derivative:
*credit default swaps.
*derivatives based on credit spreads.
*total return credit swap
credit default swaps- the swap activates on the occurrence of a 'credit even'. This can be anything that affects the creditworthiness of a company such as insolvency,default on debt obligations or a ratings agency downgrading or a specified decline in the price of a reference security.
derivatives based on credit spreads- forwards,swaps and options based on the difference on the credit spreads available between,say,a corporate bond and the relevant comparable government bond. They will be triggered by,for example,the spread widening beyond a given spread level (indicating a deterioration in credit quality).
total return credit swap- these transfer both capital and interest between the seller and buyer.

effect of uncertain inflation on debt maturity

Since inflation is generally harder to predict, the longer the period over which the prediction is made, uncertainty about inflation often leads to a reduction in the length of time over which nonindexed agreements are made. Thus the average maturity of debt issued in periods of great inflationary uncertainty is usually less than in more stable times. in some cases this can be mitigated by creative financing. key examples are " floating rate" loans, mortgages, and bonds, which provide medium-to long -term debt at short-term rates. Interest payments are allowed to vary, with each one determined by adding a fixed differential (e.g.,1%)to a specified base, such as the " prime rate" or the yield on a 90-day U.S. Treasury bill in the prior period. If short-term interest rates anticipate inflation reasonably well, such a security is at least a partial substitute for a fully indexed bond.
inflation, if allowed to run rampant, with great uncertainty about the actual level, can threaten the entire structure of a monetary economy, and with it the whole financial sector. On the other hand, it can be controlled within limits, and financial instruments can be designed to avoid some of its serious side-effects.

United States Government Securities

securities issued by the federal government are almost always considered suitable for banks. However, these securities are of various types, not all of which are available for bank investment . The major type of security excluded is encompassed by the term savings bonds, which are designed for the small individual investor. in addition, other government securities, such as those special issues designed for the government trust funds or for the federal Reserve, also cannot be acquired for bank portfolio. But most of the very large marketable federal debt is available for bank acquisition, even though particular maturities and types of government securities are particularly preferred by banks.

importance of bank loans

bank loans are, of course, not made in the same amount by the banking system every year. the extension of additional loans depends upon (1) the available loanable funds of the banking system, which, in turn, depends importantly upon Federal Reserve policy, and (2) the demand for bank credit on the part of prospective borrowers, especially business firms, This loan demand depends not only on business needs for outside funds but also on the availability of credit and equity capital from nonbank sources.
Data on bank loans for more than 25 years indicate that in the decade of the 1950's total bank loans rose by more than $68 billion, an increase of 163 per cent. The growth of commercial and industrial (business) loans nearly kept pace with total bank lending by rising by 137 per cent.
In the decade of the 1960's bank lending also more than doubled from $110.8 billion to $286.7 billion-an increase of 158 per cent. Commercial and industrial (business) lending more than kept pace as it jumped by 169 per cent. As a result.commercial and industrial lending was 37.8 per cent of total bank lending in 1969 as compared with 36.1 per cent in 1959.
In the first seven years of the 1970's, total bank lending rose by 76 per cent, while business lending of banks did not keep pace, since it increased by only 56 per cent. if this rate of increase of bank loans continued for the rest of the 1970's, the more than doubling of each of the two previous decade would be maintained. it thus seems clear that as the economy grows, so too does bank lending

source of income for the federal Deposit insurance Corporation

Having considered earlier the amount of disbursements by the corporation to depositors when banks have failed, It might be well to consider the sources of income and financial status of the FDIC. insured banks have been required since 1935 to pay an assessment rate of 1\12 of 1 per cent of their assessable deposits. The Federal Deposits Insurance Act of 1950 provided for a credit against current assessment, which first amounted to 60 per cent of the prior years 's net assessment income, but was raised to 66,2\3 per cent in 1961. In 1976 an amount of $380 million was credited to banks against their future assessments, thereby reducing the effective assessment rate in that year to 1\27 of 1 per cent of assessable deposits.
From these assessments and investment income, after deducting losses and operating expenses, the corporation was able by the end of 1976 to build up a deposit insurance fund of more than $7 billion, which was virtually all held in U.S. government securities. (in 1976 investment income was $445 million, whereas assessment income totaled only $296 million.) In the event of future insurance losses the FDIC not only can draw on these accumulated investment assets but is also authorized to borrow from the U.S. Treasury up to an additional $3 billion, if needed. So far the latter borrowing authority has never been used, because the income received by the FDIC has been far more than adequate to pay all expenses, including losses of failing banks insured by the FDIC.

Bank Deposits

liquidity of commercial banks is related not only to the amount of primary and secondary reserve that they hold but also to their demand and time deposits. In fact, changes in a bank 's liquidity ratio are often directly connected with with changes in its deposits. If there is net withdrawal of deposits from a bank, that bank will surely lose cash to other banks. The cash, of course, does not disappear from the banking system, but for an individual bank a loss of deposits means a loss of cash,just as an increase in deposits provides added loanable funds for the bank receiving the deposits.

bank liquidity (2)

the deposit structure of the bank needs to be kept in mind in the provision of bank liquidity, because some deposits are likely to be more volatile than others. Interbank deposits and public deposits, for example, tend to be more volatile than other categories of demand deposits. Hence, banks with heavy deposits in these categories need to be particularly well protected in their holdings of liquid assets, so that they can meet any unexpected heavy deposits with-drawal. Likewise, those banks that cater to large companies, which have a substantial nationwide business, may be subject to large cash drains.

bank liquidity (1)

for certain purposes, it may also be desirable to measure the liquidity of a given bank, or a group of banks, and the changes in its liquidity over time.In this event both primary and secondary reserve should be combined and the ratio of these liquid assets to demand deposits less collection items, or to total deposits, can then be computed. before we see what has happened to bank liquidity in recent years, however, it appears appropriate to examine some of the factors that effect the liquidity needs of a particular bank. One important factor is the kind of deposit drain to which a given bank may be subject. As already indicated, demand deposits have a much higher turnover than time deposits; and the ratio of demand deposits to total deposits varies widely from one bank to another. A bank with more demand deposits than another bank will therefore have a greater liquidity requirement to meet, whether this need is recognized by the monetary authorities in the from of higher legal reserve requirements or not.

Changes in the velocity of money

One of the problems that must be faced by the open Market Committee in the formulation of its monetary aggregate targets concerns the variability or lack of stability of the velocity of money, however measured, in the short run. such short-run instability of both the narrowly defined money supply, and the more broadly defined money supply. in general, on priori grounds, one would expected the income velocity to rise in a period when GNP is rising, as indeed it did in the early economic recovery period in 1975.However, income velocity declined in 1976, when GNP continued to grow but at a slower rate than in 1975. Such changes in the velocity of money, if not correctly foreseen, can be quite troublesome both for the policy makers on the FOMC and the practitioners on the Trading Desk at the Federal Reserve Bank of new York. The fact that the Manager of the System Account always attends the deliberations of the FOMC makes it possible for him to understand the spirit as well as the letter of the committee 's instructions, both as to desired targets of growth in the monetary aggregates and the amount of ease or pressure desired on the money and credit markets.

Tuesday, May 5, 2009

foreign lending of U.S. banks

In addition to the domestic lending of U.S. banks, which has been emphasized in this blog,large American banks in recent years have also greatly expanded their lending abroad,either from their home offices or from foreign branches. Such foreign lending has greatly increased because(1)the dollar is the major international unit of account,(2)international trade more than quadrupled from the mid-1960's to the mid-1970's,and(3)foreign lending was so profitable that it often accounted for half or more of the profits of large and very large American banks. At the end of 1976,total claim on foreigners of domestic offices and foreign branches of U.S.banks amounted to $207 billion,most of which was held by foreign branches.
Slightly over half of this total was to the highly developed countries in Europe,Japan and Australia in the Pacific,South Africa in Africa,and Canada in the Western Hemisphere. (These loans totaled about $115.2 billion in 1976.)some $12.7 billion had been loaned to the OPEC countries,e.g., $4.1 billion t Venezuela and $2.2 billion to Indonesia. The nonoil developing countries received $45.2 billion in loans from U.S. banks with one fourth($11.8 billion)to Brazil and another one fourth ($11.5 billion)to Mexico.Eastern Europe accounted for only $5.2 billion,whereas the offshore banking center, e.g.,the Bahamas,accounted for another $23.9 billion of loans. Despite the risk in making any kind of loan,and the special"country risks"(balance of payments difficulties and the risk of social or political upheavals)in making foreign loans,such loans had a lower loss experience than domestic loans. From 1971 to 1975 inclusive,the loss ratio on international loans of the seven largest U.S. banks was about one third of the loss ratio on the total loan portfolio. In addition to the contribution to total bank profitability of these foreign loans, the great bulk of funds to make these loans is secured from foreign sources, i.e.,deposits in branches of U.S. branches abroad. This means that these foreign loans are not being made at the expense of would-be domestic borrowers.

importance of term lending (2)

In periods of high-level capital expenditures, however, large business firms turn with greater frequency to large commercial banks. Partly it is to use bank financing as a supplement to other sources of funds and partly as a temporary substitute for capital market credit, when yields are rising in the financial markets.
TERM LENDING AS INTERIM FINANCING It has been estimated that nearly half the total capital expenditures of public utilities that are ultimately financed in the capital markets are initially financed by commercial banks. For manufacturing industries such interim financing by banks is equal to about one fourth of the capital expenditures ultimately financed by capital market flotations. The effect of both interim financing at banks plus term lending that remains with the banks until final repayment is that very large sums of money are being loaned by banks for more than one year.

importance of term lending (1)

Many short-term loans are in effect term loans, because they are more or less routinely renewed whenever they come to maturity. Likewise, businesses may borrow from banks on a pledge of business property with the intention of using such loan proceeds to finance capital expenditures, or additions to permanent working capital. in the reported statistics, however, such loans would not be reported as term loans, but would be identified instead as real estate loans. In short, reported figures show an impressive growth in this kind of bank lending. By the end of 1976, such term loans at large commercial banks totaled $45.2 billion. This was 47 per cent of the $96.2 billion total of commercial and industrial loans at these same large commercial banks. New York City banks, which account for more than a third of business loans of weekly reporting banks ($35 billion at the end of 1976), have an even higher proportion of business loans outstanding as term loans.
LARGE CORPORATIONS DESIRE TERM LOANS The demand for term loans centered heavily on New York City banks in the 1960 's and the 1970's, not only because they had enough funds to satisfy most of these demands but also because New York City banks cater particularly to large corporations. These large firms normally finance most of their operation from internal source and from the capital businesses.

Monday, May 4, 2009


REAL BILLS DOCTRINE The desirability of having commercial banks heavily specialize in this type of business lending was elaborated into a doctrine of banking both in England and the United States. In England it was called the real bills doctrine,whereas in the United States it was called the banking school theory,r the commercial loan theory. When the Federal Reserve was established in 1913,the banking school theory was in evidence,inasmuch as the act required that eligible commercial paper presented by the banks to a Federal Reserve Bank for discount should not have a maturity longer than 90 days.
The economic justification for the real bills doctrine was that the price level would tend to be stable if commercial banks restricted themselves to such inventory loans.As the money supply expanded with bank lending,so too would real goods production be increased to permit the expansion of business inventories. The pari passu expansion of goods wit money would make impossible,it was thought,any general rise of prices caused by "too much money chasing too few goods"


Nevertheless,the Survey Research Center discovered that borrowing exclusively for working capital occurs most frequently among medium-sized firms.A sizable number of such firms,however,borrow from banks for both working capital and capital expenditures.Among large firms a much smaller percentage borrowed exclusively for working capital,whereas nearly one fifth borrowed only to finance capital expenditures. An additional one fifth of large firms borrowed for both working capital and capital expenditures.
SHORT-TERM, SELF-LIQUIDATING,BUSINESS LOANS Banks are clearly interested in satisfying the credit needs of business firms as the sharp increase in the postwar period in the dollar amount of industrial and commercial loans,as shown in Table 11-1 indicates. Although these business loans may be written with maturities to fit the needs of the borrowing firms,the traditional type of business loan favored by banks was supposed to be the short-term,self-liquidating loan. This is the type of a loan that a retail business might secure from a bank in order to buy inventory before the heavy selling season prior to Christmas or Easter.

The monetary Base

Before the individual bank can increase its earning assets, it must first have added cash reserve. If a given bank has not simply increased its cash position at the expense of another bank, total bank reserve or The monetary Base must have grown. The monetary base consists of all bank reserve and all currency held by the public. The public decides how much currency it desire in relation to demand deposits by withdrawing or depositing currency into checking accounts, and banks can determine their demand for excess reserves. Nevertheless, it is the monetary authorities (the central bank and the Treasury) who decide what the total monetary base shall be.
Whenever the Federal Reserve System increases Federal Reserve credit or whenever the Treasury mints more coins or prints more currency, the monetary base increase, If the public is demand for currency is constant, when the monetary base increases, so too do total bank reserve,i.e., Member bank deposits in the federal Reserve Banks and vault cash held by commercial banks. If the banks have more reserve, they can increase the money supply by adding to their portfolio of earning assets. The money supply, However, is increased by a multiple of the increase in bank reserve as determined by the size of the monetary multiplier.

Sunday, May 3, 2009

real estate loans

the second most important kind of bank loan, is that of real estate loans or mortgage loans, which increased in amount from $11,405 million in 1949 to $149,483 million in 1976. what is perhaps remarkable, though, is the relative constancy of real estate loan as a percentage of total loans. In the entire postwar period real estate loans stayed at an almost constant ratio of about one fourth or slightly more of total bank loans. In 1949, such real estate loans were 26.8 per cent of total loans and in 1976 they were 27.3 per cent.

loans to individuals

bank loans to individuals have jumped importantly, not only absolutely but relatively as well, though there has been only a little relative growth in this type of bank lending since the mid-1950's. such loans rose form $6 billion in 1949 to $118.4 billion in 1976, which also represented an increase in their percentage of total loans from 14 per cent in 1949 to 21.6 percent in 1976. The individual is much more important customer of commercial banks now than he was earlier. the individual borrows from commercial banks for many reasons, but particularly to buy durable goods, especially automobiles.

the federal open market committee

the federal open market committee, or the FOMC as it is more commonly known, was formally established by statute when the Fedral Reserve Act was amended in 1935. At that time, it was provided that the seven members of the Board of GOVERNORS of federal Reserve System in Washington, D.C., should be members, along with five presidents or first vice-presidents chosen form the 12 Federal Reserve Banks. It was provided by law, as amended in 1942, that the method of selection should be as follows:
One by the board of directors of Federal RESERVE Bank of new york; one by the boards of directors of the federal Reserve Bank of New YORK ; ONE BY the boards of directors of the FEDERAL Reserve Banks of Boston, Philadelphia, and Richmond; one by the boards of directors of the Federal Reserve BANKS of Cleveland and Chicago; one by the boards of directors of Federal Reserve banks of ATLANTA, DALLAS,and St.LOUIS; and one by the boards of directors of FEDERAL RESERVE BANKS of Minneapolis, Kansas city, and San Francisco.


Furthermore,many businesses with large credit needs find it necessary to establish multiple credit lines, i.e, credit lines at a number of banks. Firms sometimes have multiple credit lines,so that they can meet the annual loan cleanup requirement of banks by securing a new loan from a new bank to pay off an outstanding loan at another bank.
COMPENSATING BANK BALANCES When they set up a credit line for a business borrower,most banks also establish a minimum deposit balance that will be required. The range for this minimum balance typically seems to be 10 to20 per cent. When credit is tight the minimum balance required may be increased,whereas a greater availability of credit may be reflected in a lowering of the bank's minimum balance requirement. For sales finance companies,which are important users of bank credit lines,the most common minimum balance requirement seems to be 10 per cent of the credit line when not borrowing and 20 per cent when borrowing. This reduces the funds available for the borrower to use. for example,a borrower who pays 8 per cent on a loan,but must keep 20 per cent of the loan on deposit with the bank,is only receiving 80 per cent of his loan. Hence,the borrow is really paying an effective rate of 10 per cent of the money that e can use. In computing the average minimum balance maintained,the bank is usually willing to relate this requirement to the average deposit over the entire year,though sometimes a bank insists that this minimum deposit must be maintained at all times.


A credit line is generally an informal understanding between the borrower and the bank as to the maximum amount of credit that the bank will provide the borrower at any one time. Although this arrangement is not a binding contract,most banks endeavor to honor the credit line unless some very unusual circumstance develops in the affairs of the would-be borrower. The usual duration of the credit line is one year or less,with a careful review of the borrower's situation by the bank at the end of the period.
SEASONAL BORROWING NEEDS AND CREDIT LINES Credit lines are often extended to borrowers who have large and recurring seasonal needs for bank credit.Such credit lines may be associated also with revolving credit and floor-plan financing,inventory and equipment financing,and construction activity.Business firms that often secure such lines of credit include sales finance companies,manufacturing and mining companies,commodity dealers,and trade and construction firms.All these kinds of businesses rely importantly on bank credit to help finance their seasonal needs for working capital.

Bank Rates on loans

Bank rates tend to vary with the overall demand for credit as compared with the availability of loanable funds. When borrowers,such as business firms,need more outside funds to expand working or fixed capital in order to meet increased demand for their product or service,they may turn to any one of a number of sources of loanable funds,almost certainly including commercial banks. When the credit needs of a number of important borrowers tend to increase,the price of such credit,which is the interest rate,also tends to rise.
The prime rate The key interest rate in the whole interest rate structure pertaining to bank loans is that of the prime rate. The prime rate is the bank interest rate charged on very short-term loans to very large business borrowers with very high credit ratings. These include business firms that are often household words such as General Motors and General Electric. All other bank lending rates are scaled upward from the prime rate. Hence,whenever the prime rate moves upward or downward,all other bank interest rates tend to change in the same direction.

check-credit plans

check-credit plans, on other hand, are basically a from of installment credit connected with a bank checking account. Banks had loaned some $3 billion in this from at the end of 1976 with 1 out of banks offering such a service. In a variety of forms, These check-credit plans combine elements of cashier 's checks, travelers checks, overdraft banking, and check guarantee programs. One type of check credit provides the individual with a prearranged automatic line of credit, which is activated the moment the individual 's account is overdrawn. The individual uses his regular checking account and regular checks. This means that regular checks will be honored, which otherwise would be returned to the sender.
The other major type of check credit involves plans in which a prearranged line of credit is activated by employing a special checking account and special checks provided by the bank. This is a more prevalent type of check credit than the overdraft type of check credit. About 1,621 banks at the end of 1972 offered some such bank check-credit plan.

bank Credit card

At the end of 1976, banks loans outstanding under credit cards totaled $11.3 billion which was a rise in such credit of $2.8 billion from the prior year. At the end of 1967, however only some $828 million of loans to consumers had been outstanding under credit-card plans. Bank credit, which was only 2.5 per cent of bank installment credit at the end of 1967, had risen to 5.8 per cent by the end of 1973. In this same six-year period, a similar dramatic growth occurred in the number of banks offering credit-card plans. Only 390 banks offered such plans at the end of 1967, but five years later by the end of 1972 some 8574 commercial banks were offering credit cards to their customers.
Although about 200 independent bank credit cards are operated mostly by small banks, there is a "big two" in the bank-credit-card field. Master Charge, issued by an association of banks called inter bank, is the largest bank-card operation with sales volume of $3.4 billion in 1970. National Bank American was second with $2.7 billion. In 1977, National bank americard changed the name of its card to visa. Nearly 95 per cent of all bank card credit outstanding is generated by these two systems.
Despite the widespread use to bank credit cards, many banks have difficulty in generating a profit from these owing to customer fraud, theft, default on account payments, mismanagement, collusion by merchants, and the high cost of processing records of transaction. As a result of these problem, banks issuing credit cards suffered some losses in the early 1970 's.

Saturday, May 2, 2009

Bank financing of consumer installment credit

the third most important kind of commercial bank loan volume consists of Other Loans to Individuals, which account for $118.4 billion of bank earning assets in 1976. Nearly two thirds of these individual loans were in the form of installment credit, which thus suggests that one should examine the specific role of commercial banks in the extension of consumer installment credit .
Higher proportion of Installment credit from Banks. Total installment credit held by commercial banks at the end of 1976 amounted to $85.4 billion out of total installment credit of $178.7 billion held by all holders of such credit. the proportion of such credit held directly by commercial banks at the end of 1976 was thus 48per cent as compared to 37.7 per cent at the end of 1960,36.6 per cent at the end of 1955, and only 26.3 per cent in 1940.
A Federal Reserve study prepared for Congress in 1957 estimated that actually commercial banks in 1955 were already furnishing well over half of all funds used directly or indirectly in extending consumer installment credit, because commercial banks not only make direct consumer loans but also extend sizable loans to sales finance companies ,who in turn supply credit to consumers. Commercial banks were even more important suppliers of total consumer credit in the 1970's than they were in the mid-1950's.Of the installment credit held directly by commercial banks,about $35.3 billion in 1976 was in the form of automobile paper,whereas the remaining amount was used to finance purchase of other consumer goods,for repair and modernization of home,and for personal purposes such as vacations or the payment of unexpected medical expenses. In addition,about $8.2 billion in 1976 financed the purchhase of mobile homes.

purposes of term lending

Term loans are extended by commercial banks for two somewhat different purposes.First, banks make intermediate-terms loans (five to eight years in initialmaturity) that are repaid from the borrower is earnings or other internal sources.
Second,banks extend interim credits with typical maturities of one to two years, which are then repaid from the proceeds of new bond or stock issues in the securities markets. In either case, a great advantage of this type of borrowing is that a bank term loan can be tailored to the specific needs of the individual borrower through direct negotiation with the lending bank, so that the borrower can have more freedom in determining the repayment schedule,thus permitting more efficient use of the proceeds of the loan.

term loans

An ordinary term loan has a formal loan agreement in which the period of maturity is specified at more than one year, although repayment may be either in a lump sum or in periodic installments. Other types of business loans, however, may also be term loans, event though they appear superficially to be short-term loans with a maturity of less than one year. Such may be the case with bank credit extended under revolving credit or standby agreements. Even though the note may be drawn originally with a maturity as short as 90 days, the loan agreement may permit the borrower to renew the note at maturity so that the credit may remain on the books of the lending banks for period as long as two years or more.

counter-cyclical fluctuation of bank mortgage lending (2)

After considerable credit restraint in 1966,however,bank mortgage lending was only $4.7 billion in 1967,or about $1 billion less than in the previous year.
In 1968,after a lessening of credit restraint after midyear,there was a sharp increase in bank mortgage lending. Commercial banks loaned $6.6billion in mortgage funds that year,which was $2billion more than in the previous year.In 1969,which was a year of even more severe credit restraint than in 1966,the serious adverse effects on bank mortgage lending were experienced both that year and in the following year. Bank mortgage lending in 1969 was $1.7 billion less than in 1968,and such mortgage lending declined another $2.4 billion in 1970.
In the 1973-1974 period of credit restraint,when interest rates reached new high peaks not attained in either 1966 or 1969,bank mortgage lending help up relatively well. Bank mortgage lending by commercial banks actually rose by $13 billion in 1973 over the 1972 pace,but it fell by $5.3 billion in 1974 and declined another $9 billion in 1975 from the earlier date. Bank mortgage lending,however,rose by $2.6 billion in 1976.

counter-cyclical fluctuation of bank mortgage lending

commercial banks ,like life insurance companies are more interested in mortgage lending during certain phases of the business cycle than during others. In the upswing of the cycle,when loanable funds are scarce in relation to the demand for them,banks prefer to satisfy business borrowers first and mortgage borrowers later. But when business activity turns downward and the demand for bank loans among business men slackens off,banks exhibit much greater interest in mortgage loans. The interest-rate ceiling on government guaranteed mortgages and the relative inflexibility of mortgage rates generally affect the flow of funds into mortgages as compared with other possible earning assets. it is this "stickiness"of interest rates on mortgages that helps account both for the usual lack of interest on the parts of banks and other lenders in making mortgage loans in the upswing of the cycle,and for their greater interest in making such mortgages in the downswing.
MORTGAGE LENDING BY BANKS IN CREDIT RESTRAINT The impacts of changing monetary-credit policy by the federal reserve on commercial bank mortgage lending behavior in the latter part of the 1960's(with about a year lag)are clearly revealed in federal reserve data.In 1965,and in 1966,commercial banks increased their holdings of mortgages by $5.7 billion each year.

mortgage or real Estate loans by banks

mortgage are also important earning assets for commercial banks, as evidenced by the fact that total assets in this form are second only to business loans. As indicated earlier, a fairly steady proportion of about one fourth of total bank loans has been in mortgages throughout the postwar period. Commercial banks are a considerable, but not the primary, source of funds for the mortgage market as a whole. As mortage lenders, commercial banks are exceeded in importance by saving and loan associations, life insurance companies, and mutual savings banks. Commercial banks now account for more 14 per cent of total mortgage held by all institutions. This proportion has also remained fairly constant in the postwar period.

Ratio of time Deposits Desired by the public (2)

Research studies have shown that the excess reserve ratio of banks varies inversely with interest rates on loans and securities. That is, as interest rates on such earning assets increase, banks are willing to reduce their excess holdings of cash, even though the risk factor increases somewhat.
Disregarding the risk factor and uncertainty and assuming profit maximizing behavior on the part of commercial banks, excess reserve held by banks would be Zero. such excess reserve have fallen in recent years as a result of (1) higher interest rates,(2) lower valuation of risk, and (3) greater emphasis on profit maximizing behavior.

Ratio of time Deposits Desired by the public

Changes in national income and interest rate do, However, effect the portfolio holdings of monetary assets of the public. As national income rises, we expect that ratio of currency to income will fall, since larger transaction in dollar terms tend to be paid for by check. The ratio of time deposits, on the other hand, can be expected to increase as national income increases, since time deposits, unlike demand deposits, may be regarded as "luxury goods" of which more are demanded to higher levels of income. In fact, by the 1970s time deposits of commercial banks greatly exceeded the dollar amount of demand deposits. At the end of 1976, time deposits at all commercial banks totaled $492.2 billion,which was nearly double the amount of " other demand deposits" at these banks. ("Other demand deposits" were $288.4 billion,interbank demand deposits were $45.4 billion, and U.S. government deposits were $3 billion.)
Time deposits seem to bear an inverse relationship to market rates of interest, so that the public shifts out of holdings of time deposits into other money market assets,e.g., Treasury bills, when market yields rise, and vice versa.

Bank Credit-card and Check-Credit plans

One way in which banks have expended their participation in consumer installment credit is through the extension of Credit-card and Check-Credit plans to many of their customers. After the mid-1960s, Bank Credit-card and Check-Credit plans were the most dynamic growth components of total consumer credit offered by commercial bank. some smaller banks had tried these plans earlier, and some larger banks initiated them in the late 1950s, but it was not until around 1965 and later that these plans grew significantly across the country.

Friday, May 1, 2009

losses and gains in Bank deposits

when bank loses deposits, the initial impact is ordinarily a reduction in the amount of its primary reserve-usually either vault cash or deposit in the Federal Reserve system. If the loss of reserves is such as to result in a deficiency in legal reserves,the bank will probably borrow from either the reserve bank or another commercial bank,perhaps a correspondent bank. if the decline in deposits proves to be more than temporary,the bank suffering the loss will have to reduce its secondary reserves and perhaps,ultimately,its loan portfolio.
The reserve process occurs when a bank gains deposits. When deposits rise,certain liquid assets,particularly excess reserves,will also increase. Therefore,in the short run at least,an increase in deposits may be associated with an increase in the liquidity ratio,just as a decline in deposits may be expected to be associated with a decline in the liquidity ratio. Subsequently,we would expect the bank with added excess reserves to employ these in acquiring such earning assets as loans or U.S.government securities,particularly in the intermediate maturity range so preferred by commercial banks.

high loan-deposit Ratios in New York and Chicago(2)

This considerable decline in liquidity of the portfolio, because of an aggressive search for higher bank profits,was in contrast with earlier traditional ideas held by banks concerning portfolio management. It was formerly thought that if banks increased their holdings of risk assets, i.e.,loans,they were also expected to increase their holdings of cash (primary reserves)and low-risk, low-yielding assets,such as U.S. government securities of short maturities (secondary reserves)in order to preserve their liquidity. There were,then,three major considerations that were expected to govern prudent portfolio management: (1)liquidity,(2)asset quality,and(3)income. These three objectives might also be condensed into the two opposed objectives of maximum profits and maximum safety. The latter two objectives are clearly opposed ,because the asset giving the greatest return is ordinarily the one with the greatest risk of default,whereas the safest asset is usually one yielding a low rate of return.Using the threefold classification of objectives,let us now consider liquidity.

high loan-deposit Ratios in New York and Chicago(1)

During this period,large city banks,such as those in New York City and Chicago, liquidated substantial amounts of their holdings of U.S. Treasury securities and increased their loans outstanding.As a result, banks in these two cities,as well as banks in many other large cities, came to- have very high loan-deposit ratios.
By September 1969,for example,New York City banks had a loan-deposit ratio of 84 per cent,as compared with 74 per cent for other large member banks and 63 per cent for all other member banks. The New York banks were exceeded in this high loan-deposit ratio only by the Chicago banks,which on this date had an 88 per cent ratio. Eight years later,in September 1977,New York City banks still had a high loan-deposit ratio,though it had fallen some-what to 71 per cent. Chicago banks had a 90 per cent loan-deposit ratio,other large member banks had a 79 per cent ratio,and all other member banks had a ratio of 67 per cent. The loan position of many member banks was even tighter than suggested by these ratio,because much of their holdings of Treasury securities was not available for further liquidity requirements. The Treasury securities had to be held against certain categories of deposits,such as tax and loan accounts and those of other governmental authorities.

Bank portfolio Management and its Regulation

Banks can aggressively "buy" liabilities by offering higher rates of interest on time deposits or greater services to holders of demand deposits. the form of bank behavior, called"liability management," became of great importance in the banking industry in the 1960s and 1970s. Banks have traditionally had a great interest in managing their earning assets,i.e., the proper diversification of loans and investments, and this portfolio concern has continued to be evidenced along with liability management.
In general, in the period since World War II banks have changed their composition of assets from those consisting primarily of reserve and U.S. government securities to one consisting largely of loans to the private sector and increasing amounts of securities of state and local governments. At the same time that low-risk and low-yield asset have been reduced, banks have acquired more high-risk and yield assets.
The percentage of time deposits to demand deposits has also greatly increased in this period, reducing somewhat the risk of borrowing short and lending long, which was always a danger when demand deposits were much larger than time deposits. the great growth in time deposits by commercial banks has largely been accomplished by aggressive bank managements’ paying ever-higher interest rates on such deposits in order to avoid the dangers of disinter-mediation or nonintermediation in the face of rising money market yields. in turn, the higher costs of time deposits have increased the necessity of finding higher yielding earning assets.

Adjusting the bank is Reserve position

A rather careful adjustment in reserve position is called for when, as is usually the case for large city banks, the money desk manager seeks to keep a fully invested asset position without involving reserve deficits. It a deposit inflow supplies funds that are expected to be retained by the bank for a considerable period of time,such as several months,then it is to be expected that such short-term funds would enter a longer part of the money market than the federal funds market. Such funds would probably be invested in Treasury bills,or possibly commercial paper or banker' acceptances. Likewise,a persistent deposit drain will ordinarily be met by selling such securities from the investment portfolio of the bank. But when it seems likely that the increase,or decrease,in funds arising from changed levels of bank deposits is temporary in character,one might then reasonably expect the large bank to buy or sell federal funds.

Commercial banks and the Money Market (3)

These banks are also likely to find their reserve positions affected first by any change in money market conditions arising from nonbank sources. Because of the critical importance of the participation of these large commercial banks in the money market,we pay particular attention to the character of their operations. Only about 100 banks in this country account for about 90 per cent of the gross purchases and sales of federal funds. Even nonmoney market banks,though,have some connection with the money market through their corre-spondent relationships. In short,the wole commercial banking system,by putting in or taking out excess funds from the money market,affects the market level of sort-term interest rates and availability of short-term credit. In turn,the entire banking system is affected by pressures or ease in the money market by reason of the impact of such changes on the liquidity of the banking system.

Commercial banks and the Money Market (2)

Nearly all commercial banks, however, no matter what their size,interact with the money market either directly or indirectly in their asset management. Since we have already dealt with the principles of liability management,our main emphasis will be on asset management of banks in relationship to the money market. In this context,banks may approach the money market when their reserve positions require some adjustment. A commercial bank with temporary excess reserves may wish to find temporary employment for them in the money market, whereas a bank with a temporary deficiency of reserves may wish to sell some of its Treasury bills in the money market,or perhaps buy federal funds. Furthermore,because the center of the money market is in New York City, it is the large commercial banks,either located in New York City or having correspondent relationships with New York City banks,that are likely to place initial pressure or ease on the money market through their reserve adjusting operations. The 8 New York City money market banks and the 38 money market banks outside New York City are the banks that resort most to the money market.

Commercial banks and the Money Market (1)

Although the money has a number of important participants, commercial banks play a particularly significant role,which should be carefully examined.Furthermore,it is largely through its varying impact upon commercial bank reserve positions that the federal reserve is able to affect the cost and availability of funds in the money and capital markets and thus to influence aggregate economic activity. The relationships of commercial banks to this short-term debt market are therefore of special significance.
Since banks are now concerned with bot asset and liability management,they may approach the impersonal money market for either of these purposes,particularly if they are large banks. Liability management for large commercial banks requires interaction with the money market,since an important tool of such liability management is,as has been noted,the issuance of large certificates of deposit in denominations of $100,000 or more. These CD's, in turn, are an important money market asset.
If these commercial banks wish more funds,say,to expand their business lending,then they can"buy"such funds by offering a higher interest rate on such marketable deposits. Smaller commercial banks may also wish to be more aggressive in attracting additional deposits in periods of rising loan demand. However,the smaller banks are usually restricted to offering "consumer-type"certificates of deposits in much smaller dollar amounts than are traded in the money market.